Chipotle Executing Well, But Valuation Leaves No Margin Of Error

By Stephen D. Simpson, CFA | May 14, 2013 AAA

Investors can be slow to abandon their favorite growth stocks, particularly when management has shown itself able to execute at a high level. Couple that with a very strong sector and you have a good recipe for Chipotle Mexican Grill (NYSE:CMG) to perform. While the shares are still down almost 10% from their year-ago level, they are up almost 60% from a late October bottom and investors seem to be willing once again to just look past challenging same-store traffic trends.

A Look Back To April Highlights Good And Bad News

Much as investors and analysts prize same-store growth, I think they sometimes underestimate the value of margin expansion, and first quarter results from Chipotle offer some evidence that margins can move these stocks.

Revenue rose 13% this quarter, even though same-store growth of 1% was disappointing relative to most analyst projections. Chipotle outperformed on revenue from new stores, and that helped offset the worst reported same-store sales number in the company's history as a publicly-traded stock. Adjusted same-store sales were more encouraging, though, as adjusting for calendar effects bumps the number to 3% - still not great relative to Chipotle's history, but pretty solid relative to large chains like Yum! Brands (NYSE:YUM) and McDonald's (NYSE:MCD) (though a bit slower than the adjusted growth seen at Panera (Nasdaq:PNRA)).

What I think was even more impressive was the company's margin performance. Restaurant margin did decline from last year by a point, but it improved almost two points from last year and it beat expectations by about half a point – and that's with companies like Tyson (NYSE:TSN) pushing through higher protein prices. With that, operating income rose 17% and the operating margin improved half a point from the year-ago level.

Analyzing Operating Margins

Margins An Under-Appreciated Story

I don't want to run the margin topic into the ground, but I think it's a very important part of how this story could work from here. At just over 26%, Chipotle already has restaurant-level margins superior to McDonald's and Yum! Brands, and not by a trivial amount. Some of that comes from running a premium-priced concept (or at least premium-priced relative to the quick service (QSR) industry). Some of it, too, though, should be attributed to management and a business plan that leverages a relative simple operating structure (relatively limited ingredient, modest staff, etc.).

I do believe margins could continue to improve. Excluding the ShopHouse concept, Chipotle is probably somewhere near 50% of its likely store footprint. While I don't believe management has the infrastructure in place to run a 3,000-store concept, I do believe there is some slack in the system and continuing to add stores should drive increased operating synergies and operating leverage.

There could be some near-term challenges, though. Food costs are always an unknown, but Sysco's (NYSE:SYY) recent report suggests only modest food cost inflation. There could also be government-imposed costs in the form of the Affordable Care Act and the minimum wage. Chipotle management believes that most employees will opt to pay the fine instead (it's a young workforce, and paying the fine may seem more cost-effective). Likewise, I don't know that a higher minimum wage is very likely given that Congress can't seem to get together to do much of anything these days.

SEE: Evaluating A Company’s Management

The Bottom Line

When I wrote on Chipotle back in February, I commented that the company's mid-year price hike seemed like a bad idea given the weak traffic trends. Management apparently has come to agree, as the price hike has been suspended until at least later this year. If I were running this business, I'd hold off until mid-single digit traffic comps were firmly back in hand. While this isn't the most price-sensitive customer base (and the company has its “Skillfully Made” and “Farmed and Dangerous” marketing campaigns running), why risk stalling out the growth and/or sending customers over to the competition?

I continue to expect strong double-digit growth from Chipotle. Even so, 20% long-term free cash flow (FCF) growth only works out to a price target around $350 – and that's giving a lot of the benefit of the doubt to the company in terms of margin and same-store revenue expansion, as well as a lower-than-average discount rate for the industry. With the shares around $375, I'm not saying that the stock is dramatically overpriced. Rather, I'm just saying that the market already expects quite a bit from this company and, coupled with the overall bullishness in the consumer sector, I have to wonder if the risk/reward balance is skewed more towards a negative than positive surprise.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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